What are we looking for?
Profitable companies with reasonable valuations relative to their respective sector medians.
The screen
For investors paying attention to market valuations, it would seem that recent market conditions have continued pushed stock valuations to low levels. Case in point, the current median price-to-book ratio of all stocks in the Morningstar CPMS universe (roughly 740 stocks) is 1.07 times book value. Looking over the past two decades, the last time P/B levels reached this level was in November, 2008, during the financial crisis when the median P/B ratio fell to a low of 0.94. With this in mind, I used Morningstar CPMS to create a strategy with a distinct value focus that also considers companies that continue to be profitable within their sectors. The strategy ranks stocks based on the following factors:
- P/B ratio vs. sector median (a figure of 1.0 shows that the company’s P/B ratio is exactly in line with the median value of the sector to which the stock belongs);
- Forward price-to-earnings ratio vs. sector median;
- Forward return on equity vs. sector median;
- One-year relative strength ranking (calculated as the stock’s 12-month price change, as a percentile of the universe. A measure of 99 shows that the stock is in the top 1 per cent of best performing stocks in the CPMS universe).
Only the top 250 stocks in Canada by market cap were considered. In addition, to ensure that companies are not overly leveraged, I screened for stocks with debt-to-equity ratios of 0.44 or lower (the median of the universe).
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used CPMS to back-test the strategy from December, 1993, to December, 2015. During this process, 20 stocks were purchased and equally weighted. Stocks would be sold if they fell outside the top 50 per cent of the ranked universe. Over this period, the strategy produced an annualized total return of 15.6 per cent while the S&P/TSX composite total return index produced 7.6 per cent. The 20 top qualifying stocks today are shown in the accompanying table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.